Micro Handout 20: The Coase Approach and Cap-and-Trade

Transcription

1 Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Micro Handout 20: The Coase Approach and Cap-and-Trade Coase Approach: Bargaining and deal making. To motivate Coase s approach, consider the following: When will a deal be struck and when will it be impossible to strike a deal? Question: What must be true if two (or more) parties voluntarily AGREE to a deal? Answer: At the very minimum, the deal must and make individual better off; make individual worse off. Question: What must be true if given the state of affairs in question, it is IMPOSSIBLE for two (or more) parties to AGREE voluntarily to a deal? Answer: It must be impossible to find a way to make individual better off; and make individual worse off. The state of affairs in question must be. Pareto s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most Is the state of affairs getting the most from the economy s resources? No. from the economy s resources? Yes. State of affairs is inefficient. State of affairs is efficient. Coase Approach Get the affected individuals together. Encourage them to bargain and strike deals. Continue this bargaining and deal making process until it is impossible for the parties to make any more deals. When it is impossible for the individuals to strike any more deals the state of affairs is efficient. Coase Theorem: When bargaining costs are negligible: Bargaining leads to efficiency. Furthermore, the assignment of property rights: o does not affect the allocation of resources. o does affect the distribution of income.

2 2 Simple Illustration of the Coase Approach: Mr. Smith, Ms. Jones, and a Wood Stove Mr. Smith, who suffers from asthma, is getting a new neighbor; Ms. Jones is building a house near Mr. Smith. Ms. Jones is deciding how to heat her house and has narrowed the options to two: electricity or wood. Electric heat would cost her $5,000 per year Wood heat costs $2,000 a year. Question: What is the difference in Ms. Jones s heating costs? $ Ms. Jones does not suffer from any respiratory problems; consequently, the fact that wood burning will pollute the atmosphere does not concern her. Furthermore, she is not the least bit troubled by the inconvenience that wood heat might cause her. Mr. Smith learns that Ms. Jones will be using wood to heat her home. Mr. Smith suffers from asthma. Consequently, his lungs cannot tolerate wood smoke. If the air were polluted by Ms. Jones wood smoke, he must install a climate control system in his home to filter the air. Climate control system costs $2,500 per year. Scenario #1: Ms. Jones has the right to pollute the air; that is, Ms. Jones has the property rights to air. Question: Which fuel would Ms. Jones choose? Question: How would Mr. Smith respond? A Possible Deal: Might Mr. Smith be able to bribe Ms. Jones to heat with electricity rather than wood? More specifically, would Mr. Smith offer Ms. Jones a sufficiently high side payment to induce her to switch to electricity? Question: What is the largest side payment Mr. Smith would be willing to offer? $ Question: What is the smallest side payment Ms. Jones would find acceptable? $ Question: In the end, will Ms. Jones heat with electricity of wood?. Mr. Smith install the climate control system?. Society s Perspective: Two Goals Consider the dual goals of meeting the: heating needs of Ms. Jones and air quality needs of Mr. Smith There are two ways to meet these goals: Ms. Jones heats Ms. Jones heats with wood and with electricity Mr. Smith installs climate control system Ms. Jones Costs = $ Ms. Jones Costs = $ Mr. Smith s Costs = $ Mr. Smith s Costs = $ Costs to Society = $ Costs to Society = $ Based on the collective costs of Ms. Jones and Mr. Smith, which approach is least costly?

3 3 Scenario #2: Mr. Smith has the right to clean air; that is, Mr. Smith has the property rights to air. Mr. Smith is distressed, so he lobbies Town Hall to prohibit Ms. Jones from using wood without his approval. Suppose that Town Hall supports Mr. Smith. Ms. Jones could now heat with wood only if Mr. Smith approves. Question: Now, who has the property rights to the air? Answer: Question: Which fuel must Ms. Jones choose? A Possible Deal: Assuming that Mr. Smith and Ms. Jones are still speaking, might they be able to devise a mutually benefit deal, a deal that would make each of them better off? If so, what would the deal entail? Question: What is the largest side payment Ms. Jones would be willing to offer? $ Question: What is the smallest side payment Mr. Smith would find acceptable? $ Special Deal: Ms. Jones Mr. Smith Question: In the end, will Ms. Jones heat with electricity of wood?. Mr. Smith install the climate control system?. Coase Theorem: When bargaining costs are negligible: Bargaining leads to. Furthermore, the assignment of property rights o affect the allocation of resources; o affect the distribution of income. Limitations of the Coase Approach:

4 4 California Moves Closer to Cap-and-Trade Program By Cassandra Sweet Wall Street Journal OCTOBER 20, 2011, 9:51 P.M. ET SAN FRANCISCO California took its final step Thursday toward launching the nation's most comprehensive cap-and-trade program aimed at cutting greenhouse-gas emissions. State regulators adopted final rules for the program, scheduled to start in 2013, that place a limit on emissions of heat-trapping gases, like carbon dioxide, in the state. Under the program, the emissions cap will decline over seven years, and utilities, refiners and other large polluters will have to cut their emissions or buy pollution "allowances," or permits to pollute.. Chlorofluorocarbons: Another example of an externality Approximately two decades ago, a total of 400 million pounds of chlorofluorocarbons were being emitted per year in the United States. There were three primary sources of CFC emissions: the manufacturing of urethane foam, automobile air conditioners, and cleaning solvents. 80 million pounds are emitted due to urethane foam production, 140 million due to automobile air conditioning, and 180 million due to cleaning solvents. The cost of eliminating the emissions from each source varies: Urethane Foam - 80 million pounds of emissions 30 million pounds of emissions could be eliminated at a cost of $.60 per pound. The remaining 50 million pounds could be eliminated at a cost of $1.00 per pound. Automobile Air Conditioner million pounds 20 million pounds could be eliminated at a cost of $2.50 per pound. The remaining 120 million pounds could be eliminated at a cost of $7.00 per pound. Cleaning Solvents million pounds 30 million could be eliminated at a cost of $.30 per pound. The next 90 million pounds could be eliminated at a cost of $.80 per pound. The remaining 60 million pounds could be eliminated at a cost of $1.50 per pound. Costs Per Pound of Reducing Emissions Industry Emissions Cost of reducing (millions of lb) (dollars per lb) Urethane 80 $.60 for first 30 M lbs recover and recycle $1.00 for remaining 50 M lbs replace with methylene chloride Auto Air 140 $2.50 for first 20 M lbs recover at servicing $7.00 for remaining 120 M lbs replace with HCFC-22 Solvents 180 $.30 for first 30 M lbs conservation $.80 for next 90 M lbs recover and recycle $1.50 for remaining 60 M lbs replace with other solvents Goal: Reduce emissions by 50 percent; that is, reduce emissions by 200 million pounds. Approach #1: EPA orders a fifty percent across the board reduction: EPA orders each industry to reduce its emissions by 50 percent.

5 5 Costs Per Pound of Reducing Emissions Industry Emissions Cost of reducing (millions of lb) (dollars per lb) Urethane 80 $.60 for first 30 M lbs recover and recycle $1.00 for remaining 50 M lbs replace with methylene chloride Auto Air 140 $2.50 for first 20 M lbs recover at servicing $7.00 for remaining 120 M lbs replace with HCFC-22 Solvents 180 $.30 for first 30 M lbs conservation $.80 for next 90 M lbs recover and recycle $1.50 for remaining 60 M lbs replace with other solvents Approach #1: 50 Percent Reduction 200 Million Pounds: Across the Board Reduction Industry Emission Reduction Cost Urethane M lbs: M lbs at $.60 per lb.60 = M lbs at $1.00 per lb 1.00 = Auto air M lbs: M lbs at $2.50 per lb 2.50 = M lbs at $7.00 per lb 7.00 = Solvent M lbs: M lbs at $.30 per lb.30 = M lbs at $.80 per lb.80 = M lbs at $1.50 per lb 1.50 = Total Cost of Achieving Goal Using Approach #1 Question: From the perspective of society as a whole, could the EPA achieve this reduction in a less costly manner? If so, by how much would each industry reduce emissions? Approach #2: 50 Percent Reduction 200 Million Pounds: Least Costly Method Industry Emission Reduction Cost Urethane M lbs: M lbs at $.60 per lb.60 = M lbs at $1.00 per lb 1.00 = Auto air M lbs: M lbs at $2.50 per lb 2.50 = M lbs at $7.00 per lb 7.00 = Solvent M lbs: M lbs at $.30 per lb.30 = M lbs at $.80 per lb.80 = M lbs at $1.50 per lb 1.50 = Total Cost of Achieving Goal Using Approach #2 Implementation Problems with the Least Costly Approach: Which industries reduce the most?. Which industries reduce the least?. Question: Do you foresee any implementation problems with Approach #2?

6 6 Approach #3: Cap and Trade Cap: First, place a cap on each industry so that the overall goal is met; for example, we could require each industry reduces emissions by an across the board 50 percent reduction: Actual Emissions Industry Emission Reduction Unused Reduction Capacity Urethane M lbs 30 M lbs at $.60 M lbs at $ M lbs at $1.00 M lbs at $1.00 Auto air M lbs 20 M lbs at $2.50 M lbs at $ M lbs at $7.00 M lbs at $7.00 Solvent M lbs 30 M lbs at $.30 M lbs at $.30 M lbs 60 M lbs at $.80 M lbs at $.80 M lbs M lbs at $1.50 Trade: Second, allow one firm to farm out the emission obligations to someone else. Alternatives for firms in the industry: Continue to reduce Farm out their obligations to emissions on OR reduce emissions by paying their own someone else to take them over. In general, which alternative will be chosen? Which industry has the greatest desire to farm out its obligations?. When is it worthwhile for an industry to take over someone else s obligation? To make it worthwhile for the urethane industry to take over auto air s obligations, it must receive more than $ per lb. To make it worthwhile for the solvent industry to take over auto air s obligations, it must receive more than $ per lb. Trades of Obligations: farms out M lbs to for $ per lb farms out M lbs to for $ per lb farms out M lbs to for $ per lb Generalizing the Effect of the Trades: Transfer emission reduction from industries where the cost of reduction is to industries where the cost is. Is this good or bad from the perspective of society as a whole?. Compare Approach #2 and Approach #3 Question: How are the approaches similar? Question: Which approach would have fewer implementation problems?

7 Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Micro Handout 21: Common Resources and Public Goods Two Aspects of Goods: Rival versus Nonrival and Excludable versus Nonexcludable Rival or Nonrival Does one individual s use of the good reduce the ability of others to benefit from it? Yes: Excludable Yes: Rival No: Nonrival Excludable or Nonexcludable Can individuals be prevented from using the good? No: Nonexcludable Locate the following Hamburgers Fishing in International Waters Sunday Ticket on DirecTV Tornado Siren Common Resources: Rival and Nonexcludable Common resources lead to the tragedy of the common. Public Goods: Nonrival and Nonexcludable Public goods create interesting and perplexing public policy issues for economies. These issues involve both economic and political issues. Common Resources: Tragedy of the Common Illustration of the Tragedy of the Common: Sustainable Lobster Fishing Number of Traps Lobsters Trapped 0 0 Question: Initially the number of lobsters 1 60 trapped increases, but then declines. Why? Two lobstermen: Adam and Beth.

8 2 Questions: Are lobsters rival or nonrival?. If one lobsterman traps a lobster the other cannot trap it. Are lobsters excludable or nonexcludable?. Both lobstermen have the right to set traps. Lobsters are a : Set the scene: Each lobsterman can set either one or two traps. Consequently there are four scenarios. Each lobster trap snares an equal number of lobsters of the total number trapped. Adam Sets 1 Trap Adam Sets 2 Traps Beth Sets 1 Trap Adam Traps Beth Traps Lobsters Lobsters Adam Traps Beth Traps Lobsters Lobsters Beth Sets 2 Traps Adam Traps Beth Traps Lobsters Lobsters Adam Traps Beth Traps Lobsters Lobsters Question: How many traps will Adam set, if Question: How many traps will Beth set, if Beth sets 1 trap: trap(s) Adam sets 1 trap: trap(s) Beth sets 2 traps: trap(s) Adam sets 2 traps: trap(s) Adam has a Beth has a Definition: Question: What state of affairs results? Adam sets traps and Beth sets traps. This state of affairs is called a. Definition: Question: Is this state of affairs efficient? Summary: In the presence of a common resource, results whenever each individual pursues his/her individual interests. Intuition:

9 3 Paradox of Public Goods Nonrival Nature of Public Goods: As a consequence of the nonrival nature of public goods, an inefficiently low level of the good results whenever each individual decides how much of the public good to purchase on his/her own (as occurs in a market). Therefore, if we hope to produce an efficient quantity of a public good, we cannot rely on private decisions; a collective or social decision making process must be used. Nonexcludable Nature of Public Goods: As a consequence of the nonexcludable nature of public goods, individuals participating in a social decision making process have an incentive to misrepresent their true preferences to become free riders. The collective decision making process cannot obtain the accurate information it requires to ensure efficiency. Illustration of the Paradox of Public Goods Three roommates, Peggy, Kate, and Sue, have decided to rent a DVD this evening instead of studying. Being diehard football fans, they are considering a DVD of Super Bowl XL played on February 5, 2006 at Ford Field in Detroit, Michigan. Who did the Pittsburgh Steelers defeat in Super Bowl XL? What was the final score? If they rent the DVD, the three of them could all enjoy the benefits of the DVD simultaneously when they play it on the television in their common room. Questions: From the perspective of the three roommates, is the DVD rival or nonrival?. excludable or nonexcludable?. From the perspective of the three roommates, the DVD is a. If Peggy, a Pittsburgh native, were completely honest, she would be willing to pay $7.00, but no more, to savor the awesome Steelers victory once again. If Kate, a fan of the losing team, were completely honest, she would be willing to pay $2.00, but no more. If Sue were completely honest, she would be willing to pay $4.00. To summarize: Honest Willingness to Pay Peggy $7.00 Kate $2.00 Sue $4.00 The rental fee for Super Bowl XL is $9.00. If each roommate were to decide on her own (privately) would anyone rent the DVD? Would Peggy rent the DVD on her own?. Would Kate rent the DVD on her own?. Would Sue rent the DVD on her own?.

10 4 Question: Is this state of affairs efficient? That is, could you devise a scheme in which the roommates raise the $9.00 needed to rent the DVD collectively that would make each of the roommates better off? Explain. Honest Willingness to Pay Contribution Surplus Peggy $7.00 $ $ Kate $2.00 $ $ Sue $4.00 $ $ $9.00 Question: Which aspect of the DVD is important here?. Generalize: When each roommate decides on her own nature of public goods Too results Consider Kate. In truth, she is willing to pay $2.00. What if she lied to her roommates, however, claiming that she was not willing to contribute anything to rent the DVD. Question: Could you devise a scheme in which the other two roommates, Peggy and Kate, raise the $9.00 needed to rent the DVD that would make each of them better off? Explain. Honest Stated Willingness to Pay Willingness to Pay Contribution Peggy $7.00 $ Kate $0.00 Sue 4.00 $ $9.00 Question: Does Kate have an incentive to misrepresent her true preferences?. Question: Which aspect of the DVD is important here?. Generalize: nature of public goods A person has an incentive to Collective decision making process cannot become a. obtain the information. Arrow's Impossibility Theorem: A General Approach to the Public Good Paradox A "reasonable" social or collective decision making process should: produce a clear-cut winner. be efficient; that is, if a candidate or proposal is supported unanimously, it should win. not be perverse; that is, if someone changes his/her mind in favor of the winner, the outcome should not be affected. not be affected by irrelevant factors; that is, if a losing candidate or proposal drops out, the outcome should not be affected. The only process that will satisfy these four conditions is a dictatorship.